Portugal's borrowing costs have jumped to record highs and are tracking the
moves seen in the culminating phase of Greece's debt crisis, dashing hopes
that the country will be able to stave off contagion by embracing drastic
austerity.

Demonstrators on the streets of Lisbon: Portugal has so far avoided the sorts of riots seen in Greece, but patience is wearing thin.

Yields on Portugal's 10-year bonds climbed to 14.39pc on Thursday. Credit default swaps measuring bond risk have reached 1270 points, pricing a two-thirds chance of default over the next five years.

While some of the latest damage reflects forced selling of Portuguese debt after Standard & Poor's cut the country's credit rating to junk status last Friday, there are deeper worries that sharp fiscal cuts by the free-market government of Pedro Passos Coelho may prove self-defeating.

Mr Passos Coelho has been praised by EU leaders and the International Monetary Fund for delivering on austerity, but the risk is that severe tightening - without offsetting monetary and exchange stimulus - will push Portugal into the same downward spiral that has already engulfed Greece.

Jurgen Michels, Europe economist at Citigroup, said Portugal's economy will contract by a further 5.8pc this year and by 3.7pc in 2013, a far sharper decline than official forecasts. The peak-to-trough collapse would be 13pc, a full-fledged depression.

"As this gets worse it is going to be extremely difficult to go ahead with more austerity measures: political contagion will start to come through," he said.

Portugal has so far reacted calmly. It has avoided the sorts of riots seen in Greece, but patience is wearing thin. The CGTP labour federation held a protest march in Lisbon this week, vowing to resist "forced labour".

A new study by the Barometer for Democracy shows that confidence in Portugal's democracy has fallen to the lowest since the end of the Salazar dictatorship. Barely more than half retain faith in the system and 15pc pine for "authoritarian" rule.

While Portugal's public debt of 113pc of GDP is lower than Greece's, the private sector has much larger debts and the country's total debt-load is higher at 360pc of GDP - much of it external debt.

"There is huge private sector deleveraging going on and the banking system has big problems. It is unclear how much of this private debt is going to end up on the state's door-step," said Mr Michels.

"Without a sizeable haircut to its debt stock, Portugal will not be able to move into a viable fiscal path. We expect a haircut of 35pc at the end of 2012 or in 2013."

Portugal's Treasury faces modest debt repayment of €17bn this year. There is no imminent crisis since Lisbon is already under an EU-ECB-IMF Troika regime as part of its €78bn rescue and does not need to access markets until 2013.

The problem is the slow-burn threat of debt-deflation. Interest costs for Portuguese companies are painfully high - if they can roll over loans at all - and the debt burden is rising on a shrinking economic base. Real M1 money deposits contracted at an annual rate near 20pc in the second half of 2011.

Since the country cannot devalue within EMU, it hopes to achieve an "internal devaluation" to restore 30pc in lost competitiveness against Germany. This is a gruelling process, entailing cuts that eat away at tax revenue.

Portugal is a troubling case for EU officials, who insist that Greece is a "one-off" case rather than the first of a string of countries trapped in a deeper North-South structural rift. The official line is that Portugal will pull through because it has grasped the nettle of retrenchment and reform.

Europe's leaders have vowed that there will be no forced "haircuts" for holders of Portuguese bonds. If the country now spirals into a Grecian vortex as well they will have to repudiate that promise or accept that EU taxpayers will have to shoulder the burden of debt restructuring.

While all eyes are on Greece, it is the slower drama in Portugal that will ultimately determine the fate of the eurozone.